Bid/Ask Spreads: The Hidden Cost of Every Trade (Chapter 14)
Book: Trading and Exchanges: Market Microstructure for Practitioners Author: Larry Harris Publisher: Oxford University Press, 2003 ISBN: 0-19-514470-8
Previous: Dealers and Market Makers
Every time you buy or sell something in a financial market, you are paying a hidden tax. It is not labeled on your brokerage statement as “spread cost,” but it is there. The bid/ask spread is the price of getting to trade right now, and Chapter 14 of Harris’s book is where he breaks down exactly what that cost is made of and why it varies.
Harris actually says this chapter contains “the most important lesson you may learn from this book.” Strong claim. But after reading it, it is hard to disagree.
What the Spread Really Is
The bid/ask spread is the difference between the price dealers will pay to buy (the bid) and the price they will charge to sell (the ask). When you buy at the ask and sell at the bid, you lose the spread. That is the price of immediacy. You wanted to trade now instead of waiting, and that costs money.
The spread matters in two big decisions. For traders, it determines whether to use market orders (pay the spread) or limit orders (try to earn the spread). For dealers, it determines whether they can make a living providing liquidity.
Two Components of the Spread
Economists break the spread into two pieces, and understanding these pieces is key to understanding how markets really work.
The transaction cost component covers the normal costs of running a dealing business. Staff wages, exchange fees, trading systems, clearing, settlement, office space. All the boring stuff. If everyone knew exactly what instruments were worth, this would be the entire spread. Prices would just bounce between bid and ask around the true value. Economists call this the transitory component because these price changes regularly reverse. You see the price go bid, ask, bid, ask. That bouncing is called bid/ask bounce.
The adverse selection component is the part of the spread that compensates dealers for losing money to informed traders. This is the expensive one. Dealers widen their spreads so that the money they make from uninformed traders covers the money they lose to informed traders.
Here is the remarkable thing. You can look at the adverse selection component from two different angles, and both give you the same answer. From an information perspective, it is the difference in value estimates dealers make depending on whether the next trader is a buyer or seller. From an accounting perspective, it is the amount dealers need to charge everyone to recover what they lose to informed traders. Same number either way. This result is called the Glosten-Milgrom theorem.
In most markets, the adverse selection component accounts for more of the total spread than the transaction cost component. Let that sink in. Most of what you pay in trading costs exists because informed traders are out there taking advantage of everyone else.
Why Uninformed Traders Always Lose
This is the lesson Harris calls the most important in the entire book.
Uninformed traders lose to informed traders no matter how they trade. It does not matter if they use limit orders or market orders. They lose simply because they trade.
If uninformed traders use limit orders, two bad things happen. When informed traders see a mispriced limit order, they grab it immediately. The uninformed trader fills, but at a terrible price. Or when informed traders compete on the same side, the uninformed trader’s order does not fill at all. The market moves away and the uninformed trader misses a profitable trade.
If uninformed traders use market orders, they still lose. They avoid direct adverse selection, but dealers have already widened spreads to cover their losses to informed traders. So uninformed market order traders pay the adverse selection spread as a fee. The dealer is basically charging them for bearing the risk of trading with informed people.
Even if uninformed traders flip a coin to decide whether to buy or sell, they tend to lose. A fair coin means they are right about price direction half the time. But the cost of filling their orders (the spread) eats their gains.
The only way for uninformed traders to avoid losing is to not trade. If that sounds depressing, it should. It is the central tension of market microstructure.
What Determines Spread Size
Three primary factors determine how wide or narrow spreads will be.
Asymmetric information. When some traders know a lot more than others, spreads widen. Dealers need bigger cushions to protect themselves. Spreads are widest when informed traders have material information that would significantly move prices if it became public.
Volatility. Volatile instruments have wider spreads. When prices move fast, limit orders and dealer quotes can become stale quickly. Market order traders get a timing option. They wait to see how prices move, then grab any limit orders that have not been updated. This timing option makes limit orders riskier, so limit order traders demand wider spreads as compensation.
Utilitarian trading interest. Markets with lots of natural traders (investors, hedgers, gamblers) have narrow spreads. More trading activity means dealers can spread their fixed costs over more volume, manage inventory risk more easily, and face more competition from other liquidity providers.
Secondary Factors That Predict Spreads
You can not directly measure information asymmetry or utilitarian interest, but you can observe things that correlate with them.
Stocks with lots of analyst coverage tend to have narrow spreads because analysts reduce information gaps. Big companies tend to have narrow spreads because they attract lots of investor interest and media attention. Stock index futures have very narrow spreads because nobody has reliable material information about the entire economy’s direction. (Harris notes that Fed chairmen rarely say anything interesting about interest rates precisely because they do not want to create informed traders.)
Young companies and firms in emerging industries tend to have wider spreads because they are harder to value. Commodities that depend on weather, like orange juice futures, see spreads widen when cold weather threatens the Florida orange crop. Local farmers and meteorologists suddenly have an information edge.
Markets that enforce insider trading rules have narrower spreads because insiders can not exploit their advantage. Spreads also widen around earnings announcements because some traders might have advance knowledge.
Equilibrium Spreads in Order-Driven Markets
In a pure auction market, the spread has to balance the attractiveness of limit orders and market orders. If spreads are too wide, everyone wants to use limit orders and nobody wants to pay the spread. If spreads are too narrow, nobody wants to offer limit orders and everyone wants to use market orders.
The equilibrium spread is where traders are roughly indifferent between the two strategies.
In a theoretical world where all traders are identical, know values instantly, and can cancel orders for free, the equilibrium spread would be zero. Obviously that world does not exist. In reality, limit order management costs money, traders value their time differently, and some traders are better informed than others. All of these factors push spreads above zero.
One interesting point. When limit order traders can not update their prices fast enough, they give a free timing option to market order traders. Fast traders wait for prices to move, then pick off stale limit orders. This is essentially a form of adverse selection where speed replaces information as the advantage.
When the Market Fails Completely
Sometimes asymmetric information gets so bad that no one will make a market at all. Dealers refuse to quote because the losses they expect from informed traders exceed any possible trading revenue. Harris calls this market failure.
This is why small businesses can not easily issue publicly traded stock. Nobody will buy shares in a company they can not trade. Information asymmetry is too severe. These companies have to get financing from banks and venture capitalists who do extensive due diligence and impose heavy restrictions on management.
The Bottom Line
The bid/ask spread is not just a number on your screen. It is a reflection of everything happening under the surface of a market. How much informed trading is going on, how volatile the instrument is, how many natural traders are participating. Understanding spreads means understanding who is really paying for what in every single trade.
And the most important lesson? If you do not have an informational edge, every trade you make costs you money. The only way to avoid it is to trade less.
This is part of a series on Larry Harris’s “Trading and Exchanges: Market Microstructure for Practitioners.” The book is dense and technical, but it explains the real mechanics behind how markets work. If you trade anything, it is worth your time.